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What Are Returns?

Returns, in finance, represent the gain or loss on an Investment over a specified period. It is a fundamental metric within Investment Performance analysis, indicating the profitability of an asset or portfolio. Returns are typically expressed as a percentage of the initial investment, allowing for easy comparison across different assets regardless of their initial cost. They can come in various forms, including Capital Gains from asset appreciation, income from Dividends or Interest, or a combination of both. Understanding returns is crucial for investors assessing the effectiveness of their investment strategies and for evaluating the past performance of securities.

History and Origin

The systematic study of returns and their relationship with Risk became a cornerstone of modern financial economics in the mid-20th century. Pioneers like Harry Markowitz, Merton Miller, and William Sharpe were instrumental in developing theories that quantified investment returns and their associated risks. Their foundational contributions, including Markowitz's portfolio theory and Sharpe's Capital Asset Pricing Model (CAPM), led to them jointly receiving the Nobel Memorial Prize in Economic Sciences in 1990.⁴ This recognition underscored the significance of their work in establishing a rigorous framework for understanding how financial markets price assets and how investors should construct diversified Portfolios.

Key Takeaways

• Returns measure the gain or loss on an investment over time, usually expressed as a percentage.
• They encompass both asset price appreciation (capital gains) and income generated (dividends, interest).
• Returns are a critical component of investment performance analysis, helping investors evaluate strategy effectiveness.
• Inflation and taxes can significantly impact the real purchasing power of investment returns.
• Historical returns do not guarantee future performance.

Formula and Calculation

The most basic way to calculate a simple return is as follows:

Where:

• Current Value: The value of the investment at the end of the period.
• Initial Value: The value of the investment at the beginning of the period.
• Income: Any cash flows received during the period, such as dividends or interest.

For comparing investments over multiple periods, the Compounded Annual Growth Rate (CAGR) is often used, which accounts for the effect of Compounding.

Interpreting Returns

Interpreting returns goes beyond simply looking at the percentage gain. A high return might seem attractive, but it is essential to consider the Risk taken to achieve it. For instance, a volatile asset might yield high returns in one period but suffer significant losses in another. Therefore, returns are often assessed in the context of Risk-Adjusted Return metrics. Furthermore, it is important to differentiate between nominal returns and real returns, which adjust for Inflation. Real returns provide a more accurate picture of an investor's increase in purchasing power. Comparing an investment's returns to a relevant Benchmark (such as a market index like the S&P 500) can also provide valuable context, indicating whether the investment outperformed or underperformed its peers.

Hypothetical Example

Consider an investor who purchased 100 shares of Company ABC for \$50 per share on January 1st. This represents an Investment of \$5,000 (100 shares x \$50/share). Over the year, Company ABC paid a total dividend of \$1 per share. By December 31st, the stock price had risen to \$55 per share.

To calculate the return:

• Initial Value: \$5,000
• Current Value: 100 shares x \$55/share = \$5,500
• Income (Dividends): 100 shares x \$1/share = \$100

Using the simple return formula:

The investor earned a 12% return on their investment in Company ABC over the year. This return includes both the Capital Gains from the stock price appreciation (\$500) and the Dividends received (\$100).

Practical Applications

Returns are central to nearly every aspect of finance and investing. They are used extensively in:

• Performance Measurement: Investors and fund managers regularly calculate returns to evaluate the success of their Asset Allocation decisions and individual security selections. Historical returns of major indices like the S&P 500 are often used as reference points for market performance.³
• Financial Planning: Individuals and institutions use Expected Return assumptions for various asset classes to project future wealth accumulation, plan for retirement, or meet specific financial goals.
• Portfolio Management: Portfolio managers analyze the returns of different assets to construct diversified portfolios that align with client Risk tolerances and objectives. The concept of historical returns is fundamental to quantitative investment strategies.
• Regulatory Compliance: Financial advisors and firms must adhere to strict regulations regarding how they present past performance and projected returns to clients. The U.S. Securities and Exchange Commission (SEC) Marketing Rule, for example, sets guidelines on advertising investment performance to prevent misleading information.²

Limitations and Criticisms

While returns are a fundamental metric, they come with important limitations. A significant criticism is that historical returns are not indicative of future results. Market conditions, economic cycles, and specific company performance can change dramatically, meaning past successes may not recur. Academic research, such as that by John Y. Campbell and Motohiro Yogo, has explored the complexities and potential pitfalls of using historical data to predict future stock returns, highlighting issues like persistent predictor variables and their correlation with returns.¹

Additionally, focusing solely on absolute returns can be misleading. High returns might mask excessive Volatility or significant underlying risk. Returns also do not account for taxes on gains or the impact of inflation unless specifically calculated as real returns. Furthermore, "cherry-picking" high-performing periods or specific assets to showcase inflated returns is a common deceptive practice that the SEC Marketing Rule aims to curb.

Returns vs. Profit

While often used interchangeably in casual conversation, "returns" and "Profitability" have distinct meanings in finance, especially in detailed analysis.

• Returns explicitly refer to the percentage change in the value of an investment relative to its initial cost, often including income generated. It is a rate that allows for standardization and comparison across different investment sizes.
• Profit refers to the absolute monetary gain from a transaction or business operation. It is a dollar amount (or other currency unit) that represents the excess of revenues over expenses, or the sale price over the purchase price.

For example, if an investor buys a stock for \$1,000 and sells it for \$1,200, the profit is \$200. The return on that investment is 20%. While the profit provides the absolute gain, the return contextualizes that gain relative to the initial investment, making it easier to compare with other opportunities. A \$200 profit on a \$1,000 investment (20% return) is proportionally better than a \$200 profit on a \$10,000 investment (2% return).

FAQs

What is a "good" return on an investment?

There is no single definition of a "good" return, as it depends on factors such as the investment's Risk level, the investment horizon, and prevailing market conditions. Generally, a good return would ideally exceed the rate of Inflation and surpass the returns of a relevant Benchmark while aligning with the investor's risk tolerance.

How do taxes affect investment returns?

Taxes can significantly reduce the actual amount of money an investor keeps from their returns. Capital Gains and Dividends are often subject to different tax rates, depending on jurisdiction and how long the asset was held. Investors typically focus on "after-tax returns" to understand their true financial gain.

Can returns be negative?

Yes, returns can be negative, indicating a loss on an investment. This is often referred to as a "negative return" or "loss." A negative return occurs when the current value of an investment, after accounting for any income received, is less than its initial investment.

What is the difference between nominal and real returns?

Nominal returns are the stated percentage gain on an investment before accounting for Inflation. Real returns, on the other hand, adjust for inflation, providing a more accurate measure of the actual increase in purchasing power. For example, a 5% nominal return with 3% inflation results in a 2% real return.